Investing Insights

Building Bridges

“Education is all a matter of building bridges.” – Ralph Ellison

Many of you want to become better investors but are not sure where to begin.  I have read many books on investing and have determined that the following five, when read sequentially, do an excellent job of introducing and then developing value investing skills.  I should note that I reject entirely the idea of the efficient market theory and instead believe firmly that fundamental analysis of individual securities can yield excess returns over a sustained period of time.  Such an approach requires a strong conviction in your thesis and the willingness to go against the crowd (buy when others are selling and sell when others are buying).  As Warren Buffett notes, value investing is like an inoculation.  Either you get it or you don’t.  In that regard, the first book serves as a great gateway.  If it makes sense to you, then you are liable to greedily consume the other four books.  If it does not make sense to you, then value investing probably does not fit your personality, which is perfectly fine.

The books should be read in the order listed because the first few lay a foundation for value investing necessary to fully appreciate the more complex ideas in the last two books.  In essence, each book builds a bridge to the next book, deepening your understanding of value investing as you move down the list.  I assume that the reader already has a basic understanding of financial statements, an absolute necessity for investing.  If not, then the reader can begin his or her education with the first half of the fourth book before going back and readng the first book listed.

1. The Intelligent Investor by Benjamin Graham – Ben Graham, mentor to Warren Buffett, is known as the father of value investing.  This book, often referenced by Buffett, is considered the premier book on the subject.  It was originally written in 1949 as the layman’s version of the far more technical Security Analysis written by Graham and David Dodd.   Graham was truly a classic value investor and would probably be known today more as a “quant.”  He focused solely on key metrics, such as price to equity and price to book, and paid little if any attention to the underlying business.  In fact, he would own hundreds of stocks at a time, relying on the fact that the price he paid for most of them was significantly less than the underlying value of those stocks.  Despite the lack of any emphasis on qualitative factors, this book introduces readers to the two most important investing principles all investors should understand: Mr. Market and Margin of Safety.  This book lays a great foundation the remaining books build upon.

2. Common Stocks & Uncommon Profits by Philip Fisher – Philip Fisher was a prominent investor around the same time as Ben Graham who offered a very different approach to value investing – qualitative analysis.  Fisher focused heavily on the underlying fundamentals of the businesses he was buying into and preferred to only buy good businesses (versus Graham who only cared about price).  In this book, Fisher provides the 15 points to look for in a common stock and also introduces the reader to the fallacy of over-diversification.

3. The Warren Buffett Way by Robert Hagstrom – Everyone is familiar with Warren Buffett but might not be familiar with what has made him such a unique investor.  With the coaxing of his long-time partner Charlie Munger, Buffett was among the first investors to successfully combine the ideas of Ben Graham (Mr. Market, margin of safety) and Philip Fisher (fundamental analysis, more concentrated bets) into a cohesive investment philosophy.  While Buffett has never written a book himself, he has been open about his approach to investing in his annual letters, other writings, and interviews.  Robert Hagstrom combed through years of information from Buffett’s letters and other writings to put together this book outlining Buffett’s philosophy.  The book categorizes Buffett’s approach into 19 tenets grouped by theme (business, management, financial, and value tenets).  Other than getting some insight into how Buffett thinks and providing some real life examples, the biggest contributions of this book are the idea of “franchises” (companies with a durable competitive advantage) and our first look at how to actually value a company.

4. The Five Rules for Successful Investing by Pat Dorsey – The first three books mentioned introduce us to basic investing tenets and classic value investing, walk us through the benefits of qualitative fundamental analysis, then bring it together  and show us how to value a company.  This book takes it a step further by delving into individual industries.  The first half of the book is a very basic primer on understanding financial statements and applying that understanding to valuing a company.  While helpful, that alone would not get this book on the list.  The true value of this book can be found in the second half.  The author was the head of equity research at Morningstar, and we are afforded the fruits of Morningstar’s extensive knowledge of businesses from various industries.  In the latter half of the book the author discusses 13 separate broad industry sectors, providing a description of the sector, any unique accounting relevant to the sector, key drivers of success for companies in those sectors, and a useful checklist that summarizes the key points.  I often refer to these chapters when delving into a new industry or to refresh myself on an industry I am already familiar with.

5. You can be a Stock Market Genius by Joel Greenblatt – This book delves into the specific areas of the stock market where the best opportunities for outsized return are often found, such as spin-offs and restructurings.  At the time he wrote this book, Joel Greenblatt had realized annual returns of 50% at his hedge fund for the previous 10 years.  This book is referenced often as the best resource for “special situations” investing knowledge due to the credibility of the author, the detailed examples provided, and the author’s ability to help the reader readily grasp complex ideas.  To get the most out of this book, the reader should have a solid understanding of the principles discussed in the previous four books.

I consider these books to be the basics for any value investor’s book shelf.  Other books on the topic can further supplement these books, such as Margin of Safety by Seth Klarman or The Real Warren Buffett by James O’Loughlin.  I chose to focus on the five books that are the most helpful and that build upon one another.

Where To From Here?

Becoming a successful investor involves more than just a solid understanding of value investing principles.  To become truly great, an investor should develop his or her strengths in these three other major areas: quality of earnings analysis, behavioral finance, and business strategy.

I noted above that a basic understanding of financial statements is a necessity for investing.  Quality of earnings analysis takes it a step further by being aware of the many ways that management can and does legally manipulate the financial statements to show a more favorable result than reality dictates.   Some very basic examples include drawing down reserves or delaying maintenance capital expenditures to artificially boost near-term results.  The best book I have come across on the topic is:

  • Financial Shenanigans: How to Detect Accounting Gimmicks & Frauds in Financial Reports by Howard Schilit

Secondly, we are all influenced in ways we do not understand, and that can cause us to make less than ideal decisions.  Behavioral finance tries to identify those unwanted influences upon our decision making and, by doing so, help to minimize them.  Two books that are highly recommended are:

  • Seeking Wisdom: From Darwin to Munger by Peter Bevelin
  • The Little Book of Behavioral Investing by James Montier

Finally, conducting sound fundamental analysis and being able to identify “franchises” requires a solid understanding of business strategy.  In other words, you should be able to understand and assess the merits of a company’s business model, strategy, and competitive landscape.  Otherwise, you will not be able to identify those companies most likely to possess a durable competitive advantage or to understand if a company’s historical performance is sustainable.  There are many books on strategy out there, and I have read a lot of them.  So far, I have found the absolute best to be the following:

  • Good to Great by Jim Collins
  • Built to Last by Jim Collins
  • The Essays of Warren Buffett: Lessons for Corporate America as compiled and categorized by Lawrence Cunningham
  • “The Five Competitive Forces that Shape Strategy”, Harvard Business Review, January 2008, p. 86-104 by Michael E. Porter
  • Competition Demystified: A Radically Simplified Approach to Business Strategy by Bruce Greenwald

What about Finance and Economics?

You might notice that I have not included two significant areas that most people closely associate with anything related to business: finance and economics.  That is by design.  Finance and economics are very useful for specific purposes, such as advising in a merger situation or running the Federal Reserve.  However, they are not necessary to be successful at investing.

Regarding finance, understanding mezzanine debt, swaptions, or sale-leaseback arrangements has little to no bearing on sound company analysis and successful stock picking.  No financing concept beyond basic valuation techniques discussed in the books already listed above can help you determine if a company has a durable competitive advantage, has sound management, operates under favorable industry dynamics, or is selling at a significant discount to its valuation.  In the rare event that a company you are analyzing actually has a material complex financial transaction, management should provide sufficient information for you to be able to understand it.  If management does not provide sufficient information, then they might be purposefully obfuscating to mask an unfavorable reality.

Regarding economics, most people appropriately think of macro-economics even though the discipline encompasses much more than just the broad economy.  There is a school of investors that focuses on macro-economics to inform their investing decisions.  However, I subscribe to the tenets put forth and embodied by the likes of Warren Buffett, Charlie Munger, Peter Fisher, Peter Lynch, Seth Klarman, and Bruce Berkowitz.  All of these famous and successful investors espouse a purely “bottoms-up” approach, meaning they place little emphasis on the overall movement of the economy and instead focus on identifying individual stocks that present good investment opportunities.  Peter Lynch once stated he spends about fifteen minutes a year on the economy, and Charlie Munger referred to the economy as a tide and that he and Buffett never worried about which way the tide was flowing because they were going to be swimming no matter what.

Conclusion

The great thing about investing is that you learn something new every single day, especially considering no two companies are the same.  Regardless, if you can develop a solid understanding of the four basic areas of investing (value investing principles, quality of earnings analysis, behavioral finance, and business strategy), then you are head and shoulders above the vast majority of investors and can likely look forward to favorable returns for many years.

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